How Does Life Insurance Work?

You’ve heard of life insurance. But how does it work and is it right for you?

Written by Erin Gobler / May 18, 2022

Quick Bites

  • Life insurance is a contract between you and an insurance company where the insurer promises to pay a death benefit to your chosen beneficiary when you die as long as you have paid your premiums.
  • The two types of life policies are term and permanent insurance—term life insurance is a temporary policy in which you make regular payments for a fixed amount of time, while permanent life insurance lasts your entire life, as long as you pay your premiums.
  • Permanent life insurance tends to be more expensive because it includes a cash value component, akin to a savings or investment account.
  • When buying insurance, it’s important to consider how much life insurance you need and which type of life insurance is best for your situation.

You may not want to plan for your death, but it’s the smart and considerate thing to do for your loved ones. If you are financially supporting family and friends, you will want life insurance because it can help make sure they are taken care of when you die, in exchange for regular payments. Even if you aren’t financially responsible for others, such policies are worth looking into because death doesn’t come without a cost.

If you’ve ever looked into life insurance before, you likely know just how confusing it can be. There are many different types of life insurance to choose from. Even within each type, there are many decisions to be made, from the terms of the policy to the amount of coverage.

Here’s what to know about life insurance, including what the different types are, how much it costs and how to decide if you need it.

Inside this article

  1. What is life insurance?
  2. What life insurance covers
  3. Types of life insurance
  4. Cost of life insurance
  5. Who needs life insurance
  6. How much life insurance to buy
  7. The best life insurance for you

What is life insurance?

Life insurance policies provide financial support to your family when you die. It’s essentially a contract between you and an insurance company—you promise to pay your monthly premiums, and the life insurance company promises to pay out a benefit to your chosen beneficiaries when you die. Life insurance policies can have one or more beneficiaries.

That’s the most basic premise of how life insurance works, but there are a variety of options within the world of life insurance that could be beneficial depending on your situation. We’ll explain further below.

What life insurance covers

Life insurance is designed to provide financial support to beneficiaries when someone dies. Once the insurance company cuts the check to the beneficiaries, they can use it for anything they want.

“​​Often this is used for lost wages [or] paying off major liabilities [like a mortgage],” says Jennifer Stein, a Certified Financial Planner at Priebe Wealth.

In general, people buy life insurance to support their families moving forward. As Stein mentions, it can replace a breadwinner’s income when they die. It can also pay off any debt they have, including a mortgage, auto loan and more. Finally, life insurance often helps to cover end-of-life expenses such as burial and a funeral.

When life insurance policies get denied

There may be some situations where an insurance company refuses to pay out a death benefit. Someone may have failed to pay their premiums or lied on their application; for example, the policyholder may have failed to disclose a preexisting condition and then died of that condition. That payout may be denied.

Insurance companies also have different policies around how they treat suicide and homicide. In general, an insurance company will deny a claim if someone is killed in a homicide and the person responsible was listed as the beneficiary.

In the case of suicide, insurance companies often have a clause that they’ll deny a claim if someone dies by suicide within two years of opening the policy.[1]

When you sign up for life insurance, it’s important to read your policy thoroughly to understand claim denial situations and avoid any surprises.

Types of life insurance

When it comes to buying life insurance, there are several types to choose from. Let’s dig in.

Term life insurance

Term life insurance is a contract between you and your insurance company that is valid for a fixed amount of time, usually 10 to 30 years. You pay premiums to your insurer during that time, and if you die within the policy term, the insurer will pay your death benefit to your beneficiaries.

“Term insurance is one of the most popular and cost-effective types of insurance,” Stein says. “This insurance is set for a predetermined amount of time, such as 20 or 30 years, with an annual premium each year. Once the time frame is up, the insurance is no longer in force. Because it is not a permanent type of solution, this is the cheapest type of insurance.”

Permanent life insurance

Permanent life insurance lasts your entire life, or as long as you pay the premium. As a result, no matter when you die, there will be a death benefit available for your loved ones. Permanent life insurance tends to have a higher price tag than term life insurance because it provides more than just a beneficiary payout.

These policies offer a cash value component, which means part of your premiums go into an account that you borrow against or withdraw from. Eventually, you can use the cash value to pay for your premiums to secure your death benefit coverage.

There are options even within permanent life insurance to choose from:

  • Whole life insurance: Your premiums are fixed with whole life insurance and the cash value portion grows at a guaranteed rate.

  • Universal life insurance: This type of insurance has flexible premiums, meaning you can choose to lower your payments as long as you’re paying the minimum to cover your death benefit. You may not have a guaranteed rate of return with universal life, as the interest rate could be tied to a stock market index that fluctuates.

Cost of life insurance

The cost of life insurance depends on several factors, including risk. Someone who presents a lower risk, generally meaning someone who is younger and healthier, can expect to pay lower premiums. On the other hand, someone older or in poor health is likely to pay higher premiums.

Gender is another important factor when it comes to rates. Women tend to live longer and as a result pay lower life insurance premiums.

Finally, any lifestyle risk factors will be taken into account by your insurance company. Someone with a high-risk job is likely to pay more, as is someone with hobbies that include skydiving versus those with low-risk hobbies like stamp collecting.[2]

Another important factor that will affect life insurance premiums is the type of life insurance policy you buy. As mentioned earlier, term life insurance tends to be far cheaper than whole or universal life insurance.

Here’s a look at what the average life insurance costs are, according to Policygenius[3]:

Term life insurance: The cost can range from $21.16 for a 25-year-old female to $152.08 for a 55-year-old male for a 20-year, $500,000 policy.

Whole life insurance: The cost can vary from $346 for a 25-year-old female to $1,380 for a 55-year-old male for a $500,000 policy.

Who needs life insurance

You might find yourself wondering whether you really need life insurance. The short answer is: It depends. Life insurance is important for anyone who has loved ones relying on them for financial support, including a spouse or children.

For others, life insurance may not be so important. Many young, unmarried individuals choose to skip life insurance because there’s no one relying on their income.

On the other end of the spectrum, many older individuals choose not to carry life insurance. At that point, they’ve already accumulated significant savings. If they’re retired and living off their savings and investments, they don’t have to worry about replacing income.

Even if no one relies on your income, there could be some end-of-life expenses where life insurance would be helpful. For example, when you die, someone will have to pay for a funeral and burial. Do you have enough money in savings to cover that, or will your loved one have to come up with the money? If you don’t have sufficient funds to pay for it, it may be worth buying a small policy to cover those expenses.

How much life insurance to buy

The next question worth asking is how much insurance you should buy. Unfortunately, many people drastically underestimate how much they’ll need.

“A lot of people get life insurance through their employer and think that this is enough coverage,” Stein says. “For many, it might not be. The coverage is often only one or two times the amount of your salary, and many need more insurance in addition to this.”

Stein also notes that you would quickly lose that coverage if you were to leave your job. And depending on your age and health status when you leave your job, it may be more difficult and expensive to buy individual coverage at that time.

So how exactly do you decide how much life insurance to buy? Some experts recommend using the DIME formula, which takes into account your debt, income, mortgage and education costs.

  • Debt: Add up all of the debt in your name that your family would have to pay off on your behalf.

  • Income: Figure out how much annual income you bring in and how many years you want to replace your income.

  • Mortgage: Add the amount it would take to pay off your mortgage.

  • Education: If you have small children at home, you may want to replace your income until they graduate high school and/or college.

How to choose the best life insurance for you

It can feel overwhelming trying to choose the best type of life insurance for your needs.

The first thing to consider when choosing a life insurance policy is the amount of coverage you need. That could be as low as $10,000 to $20,000 for someone who just needs to cover end-of-life expenses, or closer to $1 million for someone who is their family’s sole breadwinner, has children to support and a mortgage to pay off.

The next thing to consider when choosing a life insurance policy is your budget. As we mentioned, permanent life insurance policies are considerably more expensive than term life insurance. The cost alone makes term life insurance a better option for many people.

Many people may choose permanent life insurance because of the cash value. While it can be right for some, it’s not always the best option. According to Consumer Reports, the average guaranteed return on a whole life insurance policy is only about 1.5%.[4] But the average stock market return is about 10% per year.[5] Theoretically, you’d be better off investing that money yourself rather than paying more for a low-return life insurance policy.

For high earners, permanent life insurance is often attractive because the investment growth of the cash value isn’t taxed while it’s in the account. For individuals who have already maxed out their tax-advantaged investing elsewhere, life insurance can be another good way to defer a large tax bill.

As you can see, you need to do your homework when it comes to choosing the right health insurance for you. Be sure to reach out to a Certified Financial Planner if you hit a roadblock.

Article Sources
  1. “Suicide and Life Insurance,” National Alliance on Mental Illness, https://namimn.org/wp-content/uploads/sites/188/2018/08/Life-Insurance-Fact-Sheet-6.1.18.sa_.pdf.
  2. “8 Factors That Affect Life Insurance Premiums,” Fidelity Life, https://fidelitylife.com/learn-and-plan/insights/factors-that-affect-life-insurance-premiums.
  3. “Average Life Insurance Rates by Age, Gender, Policy Type, and Coverage Amount,” Policygenius, https://www.policygenius.com/life-insurance/life-insurance-rates.
  4. “Is Whole Life Insurance Right for You?” Consumer Reports, https://www.consumerreports.org/cro/news/2015/04/is-whole-life-insurance-right-for-you/index.htm.
  5. “Saving and Investing,” U.S. Securities and Exchange Commission, https://www.sec.gov/investor/pubs/sec-guide-to-savings-and-investing.pdf.

About the Author

Erin Gobler

Erin Gobler

Erin is a personal finance expert and journalist who has been writing online for nearly a decade. Erin’s work has appeared in major financial publications, including Fox Business, Time, Credit Karma, and more.

Full bio

Related Content